Saturday, May 8, 2010

Rational Panic - Where Are We?

Honestly, it may actually be time for Prechter to be mostly right. I love the guy and his rational arguments. I just hate that he doesn't accept Gold as real money that will be sought as a safe haven more than the U.S. Dollar. If you take his arguments for Armageddon in the stock market and price the stock market in Gold, the guy's already been right for a decade! For some reason, the cognitive dissonance he should be feeling with Gold isn't enough yet for him to recognize and let everyone know he made a mistake about Gold. Gold is a safer haven currency than the U.S. Dollar because it is real money and doesn't require a debt backing or faith in governments to do the right thing (which, of course, they won't).

Gold stocks, on the other hand, are a wild card. They can fight their way higher during a stock bear market, as they have many times in the past. They will likely fight their way through what I anticipate is a pending/fledgling stock bear market as well, but the upside rewards may be limited if we melt down and they certainly won't match the potential profits in shorting the stock market if "this is it." If you want to sit it out, just hold physical Gold and sleep well. Gold will win the battle of currencies even with JP Morgan and HSBC slapping 10 gazillion dollars worth of derivative contracts against the precious metals complex. Never forget that market manipulators always lose in the long run, as they ultimately have with the Gold price for the past 8-10 years (short term frustrations aside).

I like to speculate. Call it a weakness. It certainly seems to be one. Playing in a rigged casino with the family savings is a daunting task even for professional traders. For those who would rather just hold onto and continue to accumulate physical Gold, I understand and I have and will continue to do that. But man oh man, I think we're on the threshold of something big.

I want to show you two similar charts to give you an idea of where we could be headed next. The rhymes of history have made many a speculator rich as well as poor. The wrong rhyme can be costly, to be sure. But I think these two charts are reasonable proxies for where we are in history in economic terms:

These charts are, first, the Dow Jones Industrial Average from 1929 through the end of the spring of 1930 followed by a chart of the Shanghai Stock Exchange Composite Index ($SSEC) as a proxy for Chinese stocks over the past 3 years or so. Now, admittedly, everyone who has looked for a rhyme of the 1930s stock market crash in the Dow (the final bear market low about 2 years after the Dow chart above was at around 40) has been disappointed year after year, including Mr. Prechter. However, the global economic parallels have now become ominous. Just as in the 1930s, we have now moved into a sovereign debt crisis. The fear of currencies in the 1930s was more than palpable, it almost caused the USA to go bankrupt! After Britain, the leading economy of the day, left the Gold standard and changed the international monetary system from stable to nightmare by decree, everything changed quickly.

In other words, Britain defaulted on its obligations to the world. When the US did this in 1971, I assume you know how the Gold price did during the following decade. Well, in the 1930s, almost every country followed Britain's lead and abandoned the Gold standard. The U.S. decided to do "the right thing" and remain on the Gold standard. Do you know what happened to the U.S. because of this decision? Unbacked paper debt notes from around the world poured into the country seeking to redeem their currency notes for U.S. currency notes. Why? Mostly, so they could then turn around and redeem the U.S. currency notes for physical Gold! Even Americans smelled a rat and turned in their paper for Gold in record numbers - nobody thought the U.S. would continue to honor their Gold commitment and, of course, they didn't. Gold fever gripped the world almost overnight back then as people scrambled for safety and capital preservation that could be hidden away from the prying eyes and arms of global governments.

What do you think Europeans, who are strangely leading the charge into sovereign default all over again, are doing with their paper currency notes right now? Do you think they would rather exchange them for Gold or U.S. paper notes backed by nothing? Remember the end game: the currencies of the world will be devalued by hook or crook. Only Gold can survive the apparatchik onslaught coming to an economy near you soon.

Of course, I digress a little, but the point is an important one. One can attempt to play the short side and speculate or just hoard Gold and wait for asset prices to collapse further in Gold terms (which THEY ABSOLUTELY WILL) and be ready to buy near the bottom. I choose to do both, for better or worse.

The counterargument is that the currency will be debased so fast and so far that stocks will keep going up. I think China and Europe are real-time current proof that governments and their central bankstaz aren't good at anything but looking out for themselves. Europe has seen a panicky decline in the Euro that has matched its stock market plunge, causing a loss that is twice as large! There will be more fat finger trade days ahead. By the way, if you buy that explanation for the recent market meltdown, you are a paperbug. There is still time to change, kind sir or madam, but it's getting late in the game.

Here's a 20 month weekly candlestick chart of the French stock market ($CAC) that highlights the problem with the CNBC paperbug recovery crowd bedtime story:

I also used the example of China above for a specific reason: the Shanghai stock market index ($SSEC) peaked in August last year (Hong Kong [$HSI] was in November). This should scare the crap out of U.S. equity bulls. AUGUST?! If China's stock market smells trouble ahead for its economy, what does this mean for the rest of the world? China should be leading the recovery if everything is alright with the world, no? Isn't this where the so-called "global growth engine" resides? If not China, who is set to lead the world out of its economic depression?

So, where are we and where are we headed? I think we're on the brink. It may not be any more dramatic than was experienced last week (wasn't that enough?). In the short-term, we are oversold in U.S. markets but that doesn't mean we won't get more oversold. A safe play is to wait for a multi-week bounce from the eventual short-term bottom, as its character should be informative. I like China as a short and I am liking commercial real estate as a no-brainer, keep-it-simple shorting opportunity (just like in 2008). Here's a 5 year weekly log scale candlestick chart of the Dow Jones US Real Estate Index ($DJUSRE) with my thoughts:

The bottom line in my opinion is that there are some things to do and some things to not to do over the intermediate term:

Do: Get ready to go short when a decent multi-week bounce occurs and/or buy Gold on any multi-day correction as the best cash equivalent paper debt notes can buy. U.S. Dollar cash should hold up OK in the short-term but I think Gold will do better.

Do not: Be a die-hard stock bull; try to play bottom feeder in real estate or the stock market right now; try to get cute and pick the best paper currency (i.e. Swiss franc, Australian Dollar, Yen) when Gold is the best cash equivalent in the world right now and for the foreseeable future; or think the Dollar is going to collapse right here and right now so you can just go out and buy copper and oil and come out ahead.

Question mark: Gold stocks. I am a believer, but I have a feeling my faith may get tested and I will jump ship if they start acting sketchy. Not for the faint of heart. However, if we have another melt down and Gold stocks get briefly sucked into the vortex, borrow from Peter and avoid paying Paul if it means you can afford to buy even one more share of your favorite Gold stock near the bottom.

The Dow to Gold ratio is going to 2 (and may well go below 1 this cycle). For those who think everything will be OK, I give you Greece, a country whose financial house is in only slightly greater disarray than the mighty United States when honest accounting methods are utilized: